As a real estate investor, I appreciate a good tenant who pays rent on time and takes care of my property. However, one of the reasons I became a real estate investor was to help others buy a home. I always said I would help if a tenant wanted to buy my property and become a homeowner.
Buying a home is a big step and possibly your most expensive purchase ever! In some markets, affording a home is a challenge. But, don’t let the price of a house keep you from buying. This article will show you how to buy the house you can afford.
Step 1: Check Your Credit Report
With discipline and a savings plan, you could purchase a home with cash like I did for an investment property. Or you could inherit a fortune from a long lost relative. But you and I both know, it’s more likely that you will apply for a mortgage loan to buy your first home.
Before you go house hunting or look for the perfect lender, check your credit. You have the right to a free consumer credit report once a year or whenever you are denied credit due to something on your credit report. Just remember, you can access your consumer credit report for free, but you may have to pay to see your consumer credit score.
Lenders offer buyers with higher credit scores better interest rates. So, use these tips to raise your credit score even if you have debt.
Consumer Credit Score vs. Mortgage Lender Credit Score
When you look at your credit score on sites like Credit Karma or Credit Sesame, you are accessing your consumer credit score. This score and the related consumer credit report are available to you, but your mortgage credit score is most likely several (10-40) points lower.
Here’s why. Lenders use different algorithms to calculate your industry credit score. Mortgage lenders have a score and report they use to evaluate you for mortgage loans, just like car lenders have a credit score and calculation method. Therefore, your credit score varies depending on the industry.
However, the data on your consumer credit report and your mortgage credit report should be the same. Both reports include information about accounts you have open, how much you owe and payment history, including late payments.
Rather than focusing on a score, invest time in ensuring your credit report is error-free. It’s crucial to dispute errors on your credit report and pay your bills on time. These two factors can impact your credit score the most. Also, while going through the home buying process–do not apply for any new loans or credit cards.
You should shoot for the highest credit score possible before visiting a lender. Just don’t be surprised if the score you can see is different from what the mortgage lender uses for your loan application.
How Interest Rates Relate to Mortgage Credit Scores
Buyers with a credit score of 780 or higher, qualify for the best interest rates from mortgage lenders. Lenders offer applicants with a score of 680 or lower the highest interest rates. Interest rates start to decline when you have a 700-719. Lenders offer more competitive interest rates to applicants with a score of 720-779.
If you don’t have a 720 right now, that’s ok. You can take action to increase your credit score. You can qualify for a Federal Housing Administration (FHA) loan with a 520 credit score, but most lenders prefer a score of 620 or better. With an FHA loan, if your credit score is lower than a 620, you may need cash and stable employment to qualify for the loan. Lenders may also want you to have a job with possible income increases and no patterns of derogatory credit history.
Helpful tips: Before paying for your consumer credit score or report, see who will give you access to it for free. Check with your credit card companies or bank to see if they allow customers free access to their consumer credit score. You can also use sites like Credit Karma or Credit Sesame.
There are three major credit bureaus, Experian, TransUnion, and Equifax. At least once a year, review your report at all three credit bureaus. If any credit report has derogatory information, find out why. It’s important to report, dispute, and remove negative information before you apply for a loan. Take swift action while your records and memory of the incident are fresh in your mind.
Step 2: Calculate How Much House You Can Afford
To calculate how much house you can afford, first add up your monthly income. Your mortgage payment should not be more than 30-33% of your take-home pay. That’s after taxes folks!
For example, if you bring home $2,500 a month and your partner makes the same, your take-home pay is $5,000. Therefore, your mortgage should not be more than $1,650. In this example, I assume your total mortgage payment includes your principal and interest payment, homeowner’s insurance, property taxes, and private mortgage insurance (PMI).
You can also use this mortgage calculator to help you figure out your monthly payment. In the calculator, plugin the average cost of homes where you live, your mortgage rate, and the cost of insurance. Warning, this calculator doesn’t predict how much money you would qualify for, but it does estimate your monthly expenses.
The Basics Behind Private Mortgage Insurance (PMI)
You can save money on your mortgage payment if your downpayment is 20% or more. If you get a conventional loan, most lenders only require private mortgage insurance (PMI) if you put down less than 20%. PMI is an insurance premium you pay, but it only benefits your lender. If you stopped paying your mortgage, your lender is paid the balance of the home loan because you paid for mortgage insurance.
If you are required to get PMI, ask your lender what amount of equity you are required to have before you can remove PMI. Some companies want you to have 20-25% equity before they remove PMI. Furthermore, if you have an FHA loan, mortgage insurance is never taken off unless you refinance to a conventional loan.
Some lenders may allow you to put down less than 20% with no PMI. However, the lender is most likely going to offer you a higher interest rate. If you can choose between PMI or a higher interest rate, go for the interest rate. You can write-off mortgage interest on your taxes, but you cannot write off PMI.
Type of Mortgage
If you can swing it, I recommend you seek a 15-year mortgage. Sometimes the monthly mortgage payment is just a few hundred dollars more than a 30-year mortgage, and you are out of debt much faster.
So try to find a house you can afford with a 15-year mortgage that doesn’t exceed 33% of your income. If this is tough because your market has more expensive housing costs, go for the 30-year mortgage.
You don’t want to stress out about paying your mortgage. If a 30-year mortgage will give you more breathing room in your budget or is all you will qualify for, then it’s ok to take it.
Helpful tip: If you pay half of your mortgage biweekly, you’ll make 13 total payments a year instead of 12. This extra payment, when applied to the principal balance, can help shave years off your mortgage.
Not all lenders will allow you to make biweekly payments. Therefore, check with your mortgage company first to confirm they accept biweekly payments. If they hold partial payments instead of applying them to your balance, you can still make the extra payment per year. Divide your monthly mortgage payment by 12. Then pay that amount extra each month. Make sure to let your mortgage company know to put the excess money towards the principal balance only.
Step 3: Save For Your Down Payment
Save consistently and often. When you start to save for your home’s down payment, look at what expenses you can cut, so you spend less money each month. Then, take your savings and put it into your savings account for your home.
Your goal should be to save at least 20% of the cost of the home you plan to buy. For example, for a home that costs $100,000, your down payment would be $20,000.
Also, you will need money for closing costs. In some housing markets, you can ask the seller to help with closing costs, but in competitive markets, this request is less likely to be accepted by the seller. Also, do your research to see what down payment programs exist in your area. Depending on your income you may qualify for down payment assistance programs.
Most lenders want to see you have money for a down payment and closing costs before they provide you loan pre-approval. In pricey cities like New York or San Francisco saving, 20% may seem impossible. But don’t get discouraged. Get creative!
Ways to Raise a Down Payment
Do some spring cleaning and sell things you don’t need. Also, share your goal with family and see who would be willing to help. Your mom, dad, and other family members can give you financial gifts to help you with your down payment.
However, lenders do like to see you have some skin in the game. So don’t rely on your family to provide all of your down payment. If your savings plus any gifts are still less than a 20% down payment, expect to pay for private mortgage insurance (PMI) or take a higher interest rate to avoid PMI.
How to Buy with Less than 20% Down
If you qualify for an FHA loan, you could put down as little as 3.5% down. FHA loans offer you homeownership with the lowest down payment. However, FHA loans always include mortgage insurance, and sometimes a portion of the mortgage insurance is required upfront.
Mortgage insurance on an FHA loan tends to be much higher than private mortgage insurance on a conventional loan. Compare your potential FHA mortgage payment to a conventional loan payment. If you qualify for a conventional loan and can pay a down payment of less than 20%, that might be cheaper than getting an FHA loan with mortgage insurance. There are some markets where homeowners can qualify for a conventional loan with as little as 3% down.
Remember, you cannot remove mortgage insurance from an FHA loan. You will pay mortgage insurance on an FHA loan regardless of how much equity you have in your home. So do the math and see which deal works best for you.
Have Money for an Emergency
Unless you can predict the future, it’s always a good idea to have money saved for an emergency. Buying a home can be exciting, but if the down payment for your home will deplete your savings, you can’t afford that house. A down payment of 20% or more is beneficial, but should not include funds set aside in your emergency fund. As a homeowner, you must be prepared to pay a mortgage and unexpected home repairs.
After you earmark a portion of your savings for your down payment, you should still have at least one month of your monthly expenses in your emergency fund. Three months of savings are even better.
Step 4: Find the House You Can Afford
Once you’ve saved all or most of what you need for a down payment and know what you can afford, then you should visit a mortgage lender. A lender can review your credit, provide you a pre-approval letter, and set your home loan budget. A pre-approval letter is vital because it shows sellers and real estate agents; you are a serious home buyer.
If you want your buying process to go even faster, ask your lender if they can provide full loan approval before you find a home. If your lender agrees, you can house shop like a cash buyer. Once you find the house you can afford, all you need is an appraisal to finish the loan.
Just note, if a lender says you qualify for a $300,000 home loan, that doesn’t’ mean you have to spend that much on the house. Before looking at homes at the height of your budget, ask a real estate agent to show you homes that do not exceed 33% mortgage payment figures.
Your mortgage payment, down payment, interest rate, closing costs, and sometimes your PMI are all based on the price of your home. So shop for the most affordable house that meets your family’s needs. Take into consideration the location, home size, and items that you may be able to upgrade after the home is purchased–saving you money on the purchase today.
Related: How COVID-19 has impacted the Real Estate Market
Other Factors to Consider
A home inspection, appraisal, and closing costs are additional expenses you have to pay outside of your mortgage payment. Sometimes the seller will agree to pay for the home inspection, but you are fully responsible for an appraisal. If you decide to not buy a home after an inspection or appraisal, you cannot get your money back for either of these costs.
In your hunt for the perfect house, if you put an offer on a house that needs work, use the inspection report to help you decide if you want to buy the home. Your inspection should reveal repairs the house may need immediately or in the future.
You shouldn’t but any house that needs a lot of costly repairs to be livable, unless you have money to do the work. A renovation of a home may delay how soon you can move in, and you should think through where you and your family will live in the meantime and give yourself cushion just in case repairs are delayed. Furthermore, most lenders won’t approve a loan on a house that requires too much work before move-in.
Depending on where you live, the housing market could be hot all year round. However, in some markets, winter is a great time to find house bargains. New construction builders tend to offer specials to get families in their homes by the spring, and homeowners who sell in the winter may be looking to close fast. I call these people, motivated sellers, and they may be more open to negotiating their home’s price.
Be patient during your home search. In more competitive markets, you might put an offer on several homes before your offer is accepted. Use that time to refine your “must-have” list and to save more money for your down payment and closing costs.
If you are a new homeowner, please share how you prepared for this important milestone. What tips can you share with the PoM community?